P/E Ratio

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P/E Ratio

Please make sure you have the most updated mfd_dm, mfd_ta and mfd_tex packages for Stata installed for this post.

Price to earnings (P/E) ratio is: How much the market is paying for each dollar of earnings. It is calculated by dividing market price of the stock by earnings per share. However, the price is paid once to purchase the stock and earnings are realized every year. Thus, the P/E ratio is based on investor expectations of future earnings.

If we have a P/E ratio of comparable firms or of the overall market, then we may be able to calculate an expect price for a company of our choice.

If the market is willing to pay $10 for each dollar of earnings of a comparable firm and if we expect our company’s annual earnings to be $5 then the expected price for our company would be $10 X $5 = $50.

Screen Shot 2013-12-25 at 5.53.13 PM

Last\_T{\thicksim}e is last traded price. Earnin{\thicksim}e is earnings per share. Price\_{\thicksim}s is the P/E ratio. averag{\thicksim}E is the average P/E ratio for these companies. price\_{\thicksim}e is the price calculated using the P/E multiple.

Please note that this table is for illustration only. The earnings per share used in P/E multiple calculation is the expected earnings per share. The earnings per share that we used above is the earnings per share that is already announced. Also, we simply took the Dow Jones composite index companies. These companies are not necessarily comparable to each other. Proper P/E multiple calculate should be between comparable companies. The example above is to show you how to calculate and use P/E multiple.